Protect your heirs from an IRA tax trap

By Glenn Ruffenach

Worried about your adult children blowing through their inheritance? Two strategies can help holders of individual retirement accounts curb an heir’s impulse to “cash out.”

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Splurging with an inherited IRA could cost you.

The average IRA balance among individuals age 70 and older is just over $144,000, according to the Employee Benefit Research Institute in Washington, D.C. An individual who inherits an IRA can stretch required annual withdrawals over his or her lifetime. But acquiring a six-figure account might tempt heirs – especially those in their 20s or 30s – to draw down the entire amount, resulting in a big tax bill.

The first option involves naming a trust as the beneficiary of the IRA, instead of having the account bequeathed directly to one’s heirs. The trustee then distributes assets from the account to the inheritors according to the original owner’s wishes.

The problem: Such trusts must comply with strict Internal Revenue Service rules. Unfortunately, says attorney Natalie Choate of Nutter, McClennen & Fish in Boston, “many estate planners are not aware of the problem and could draft a trust that does not qualify.”

If the trust ends up being disqualified, all the funds in the account would have to be distributed to the beneficiaries within five years of the owner’s death, in most cases.

A second option, according to Choate, is to use a relatively new invention known as a “trusteed IRA” or an “individual retirement trust.”

In this case, the IRA provider serves as trustee and distributes the IRA assets to beneficiaries as the original owner directs. The upside: You save the cost of drafting a separate trust. The downside: Trusteed IRAs typically have higher fees and minimum-balance requirements than regular IRAs.

How does it work? With a trusteed IRA, you must allow your heirs to receive the IRS-prescribed annual required minimum distributions. (Typically, such payouts must begin by Dec. 31 of the year following the year of the surviving parent’s death.) But you can bar any distributions beyond that. Or you can give the trustee discretionary authority to distribute additional amounts as needed.

You also can stipulate that, once a child reaches a certain age, the IRA be turned over to him or her outright. And you can have separate accounts for multiple beneficiaries.

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Encore looks at the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities, needs and priorities of people saving for and living in retirement. Our lead blogger is editor Matthew Heimer, and frequent contributors include editor Amy Hoak, writer Catey Hill, and MarketWatch columnists Elizabeth O’Brien, Robert Powell and Andrea Coombes. Encore also features regular commentary from The Wall Street Journal retirement columnists Glenn Ruffenach and Anne Tergesen and the Director of the Center for Retirement Research at Boston College, Alicia H. Munnell.